Report may fuel rates hike debate

The March quarter consumer price index report looms large this week, with a higher than expected result quite possible on Wednesday, which would test the nerves of Reserve Bank officials and potentially move them closer to a tightening bias.

Should the underlying CPI result again surprise on the high side, speculation of higher interest rates this year will likely intensify, which could be the catalyst for pushing the Aussie back to the discomfort of parity with the US dollar. We could forget about the RBA trying to talk the currency down again any time soon.

Recall that the RBA’s two preferred measures of underlying inflation – the weighted median and trimmed mean – rose a surprisingly large 0.9 per cent in the December quarter, which pushed annual underlying inflation to 2.6 per cent. Together with a weaker Aussie earlier this year, the December quarter inflation surprise was enough to goad the RBA into raising its near-term inflation forecasts in the February Statement on Monetary Policy, with annual underlying inflation expected to hit 3 per cent in the June quarter this year.

Based on the latest forecasts, the RBA’s inflation expectation remains on track – but only just. For the RBA’s forecast 3 per cent underlying inflation in the June quarter of this year to hold up, underlying inflation can rise on average 0.7 per cent in each of the first two quarters of this year. Encouragingly, economists on average expect underlying inflation to only rise by 0.7 per cent in the March quarter – which can be considered a neutral outcome, and likely to cement the RBA’s neutral interest rate bias for at least a while longer.

But as noted by
National Australia Bank
senior economist Spiros Papadopoulos, the risks appear on the upside. For starters, the March quarter is a seasonally high inflation quarter, which could risk pushing up underlying inflation also – even on a seasonally adjusted basis.

What’s more, despite the recent rise in the Aussie, it still fell 3.4 per cent against the US dollar in the March quarter, to be 9.3 per cent below its average in the March quarter last year. And after a strong show in the December quarter, retail sales have remained firm in the first two months of the year. Firm demand and a weaker dollar suggest retailers remained well placed to continue rebuilding depressed profit by lifting prices – as was evident last quarter – especially now increased online competition seems to have quickened the pass through of currency changes into consumer prices.

In the non-tradable sector, firm housing demand and sticky service sector prices – especially in areas less subject to competition, like utilities, health and education – could also keep price pressures elevated.

Chances are underlying inflation could rise by less than 0.7 per cent in the June quarter if the Aussie holds its recent gains. The NAB March quarter business survey also points to an easing in retail price pressures, and it remains the case underlying wage growth remains subdued. Either way, the RBA may face the uncomfortable prospect of two higher than expected inflation outcomes in a row – leaving it with a fair bit of explaining to do.